New York factory performance fell to a seven-month low in December, according to the Federal Reserve Bank of New York's "Empire State" general business conditions index. Also in December, U.S. homebuilder sentiment remained at a record low for a third consecutive month, an industry group said.

The reports appeared to lend support to the view expressed by the San Francisco Fed economist that the nation faced a heightened risk of recession as a result of the interbank lending crunch, falling home prices and high energy costs.

In the San Francisco Fed's latest "FedViews" newsletter, the bank's associate director of research, Glenn Rudebusch, said there appeared to be "a significant chance of registering at least one quarter of negative GDP growth, which in the past has often been associated with a recession."

Rudebusch predicted "anemic" economic growth through the spring of next year.

"(The) economy is in a slowing trend," said Gary Pollack, head of fixed-income trading at Deutsche Bank Private Banking in New York. "The markets are extremely nervous and so is the Fed."

The Federal Reserve's looming liquidity experiment also served as reminder of a pervasive crisis in credit markets.

Many believe the upcoming funding auctions, undertaken in coordination with other central banks, will provide only a temporary stop-gap to tighter lending conditions resulting from huge exposure to mortgage-linked bonds.

"Banks need to come fully clean on their losses," said T.J. Marta, fixed-income strategist at RBC Capital Markets in New York.

Investors, expecting this process to be painfully drawn out, jumped back into Treasuries despite data last week showing a surprise rise in inflation. Weaker stock prices also helped, with the Dow down nearly 1 percent in mid-afternoon trade.